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Hey friends

I hosted Anton (Partner @ Flashpoint VC) on the podcast. He kept mentioning the importance of TAM. They invest in B2B Saas across Europe and Israel. One of the most important slide for him is the market sizing. He wants to see how you do it, what information is there, the approach behind it, and why your TAM needs to be astronomical high for VCs.

So, today's edition is about that. I'll share what TAM, SAM and SOM are, how you calculate them, why you need them, some real examples to understand the concepts even more.

Understanding TAM, SAM, and SOM

To effectively communicate your market potential, you need to grasp three key concepts: TAM, SAM, and SOM.

TAM (Total Addressable Market): This is the total revenue opportunity available if your product or service captures 100% of the market. It’s the broadest view of your market potential, and while you’ll never capture the entire TAM, it sets the stage for understanding your business’s scale.

SAM (Serviceable Addressable Market): This is the portion of TAM that your product can serve, considering your business model and geographical constraints. It’s a more realistic view of the market you can address with your current capabilities.

SOM (Serviceable Obtainable Market): This is the actual portion of SAM that you can realistically capture in the short term. It’s based on your market share, competition, and growth strategies.

Why a Big TAM Matters

For VCs, a large TAM is crucial because it signals potential for significant returns. Here’s why:

1. Scalability: A large TAM indicates that there’s room for your business to grow. Investors want to see the potential for your company to scale and become a major player in the market.
2. Investment Justification: VCs need to justify their investments. A larger TAM suggests that even capturing a small percentage of the market can lead to substantial revenue.
3. Market Dynamics: A big TAM shows that the market is worth pursuing and has the potential for high rewards. It’s an indicator of market health and opportunity.

Calculating TAM, SAM, and SOM

Total Addressable Market (TAM): TAM is the “pie in the sky” number representing the absolute maximum revenue your business could generate if every single potential customer became a paying customer. Here are three methods to calculate it:

1. Top-Down Approach: Utilize industry data, market reports, and research studies to estimate the market size. This method is less specific but can provide a broad overview.
2. Bottom-Up Approach: Calculate TAM based on the total number of potential customers and the average revenue per user (ARPU). For example, if you sell medical software at $1,000 per license and there are 1,352 hospitals in Australia, your TAM is $1.35 million.
3. Value Theory Approach: Estimate TAM based on the value customers place on your product. This is useful for innovative sectors where traditional market data might not be available.

Serviceable Addressable Market (SAM): SAM represents the portion of TAM that your products and services can realistically serve. Here’s how to calculate it:

1. Continuation of Bottom-Up Approach: Start with the TAM calculation and narrow it down to the segments your product can serve. For example, if your product is more relevant to public hospitals, calculate SAM based on the number of public hospitals in your target market.
2. Example Calculation: If there are 695 public hospitals in Australia and your software’s annual contract value is $1,000, your SAM is $695,000.

Serviceable Obtainable Market (SOM): SOM is the actual market share you can capture in the short term. It’s based on your current customers and market penetration.

1. Market Share Calculation: Determine last year’s market share and multiply it by this year’s SAM value. For example, if you had $400,000 in revenue last year and the SAM is $715,000, your market share is 0.58 (58%).
2. Example Calculation: Multiply the market share by the current SAM to get your SOM. In this case, it would be 0.58 x $715,000 = $414,700.

Why Do TAM, SAM, and SOM Matter to a Startup?

For a startup, TAM is crucial for attracting investors. A “Goldilocks” TAM, not too high or too low, is ideal. Too high suggests heavy competition, while too low limits growth potential. The right TAM balance excites investors.

Let me explain that with numbers.

Hypothetical Example: The $100 Million TAM

Let’s consider a hypothetical startup that has identified a TAM of $100 million. The product is a niche software solution aimed at a specific segment of the healthcare industry.

Scenario Breakdown:

• TAM: $100 million
• SAM: $50 million (assuming the product serves half of the total market due to specific feature relevance)
• SOM: $10 million (realistic market share that the startup can capture in the first few years)

Investment Perspective:

• Initial Market Capture: Even with an aggressive growth strategy, the startup can realistically capture $10 million in market share within a few years.
• Revenue Potential: Assuming the startup achieves its SOM, the annual revenue would be around $10 million.

Why VCs Might Not Be Interested

1. Limited Upside Potential: A $100 million TAM implies that even if the startup captures 100% of the market, the maximum revenue potential is capped at $100 million. This is relatively small compared to markets where TAMs are in the billions.
2. Risk vs. Reward: VCs take significant risks when they invest in early-stage startups. They look for opportunities where the potential rewards justify these risks. A smaller TAM means that the potential return on investment (ROI) is limited, making it less attractive.
3. Scalability Concerns: With a TAM of $100 million, there’s less room for scaling the business. Even if the startup performs exceptionally well, its growth potential is constrained by the size of the market.
4. Exit Opportunities: VCs also consider exit opportunities. A company in a small market may struggle to find acquirers or may not be able to go public, limiting the exit strategies available to investors.

Comparative Perspective: The $10 Billion TAM

Now, let’s compare this with a startup targeting a TAM of $10 billion in the broader healthcare software market.

Scenario Breakdown:

• TAM: $10 billion
• SAM: $5 billion (more specific but still broad segment)
• SOM: $500 million (realistic market share that the startup can capture in the first few years)

Investment Perspective:

• Initial Market Capture: Even capturing a small market share (5%), the startup can achieve $500 million in revenue.
• Revenue Potential: The potential for high revenue makes the investment more appealing.

Why a Larger TAM Attracts VCs

1. Higher Upside Potential: A $10 billion TAM means that even a modest market share can result in significant revenue. Capturing just 1% of the market translates to $100 million in revenue.
2. Better Risk-Reward Balance: The potential for high returns justifies the risks involved in early-stage investments. VCs are more likely to invest in opportunities where the upside is substantial.
3. Scalability: A larger TAM provides ample room for the business to grow and expand, making it more attractive for investors looking for scalable ventures.
4. Attractive Exit Opportunities: Companies in larger markets are more likely to attract acquirers or reach an IPO stage, providing more exit opportunities for investors

Five Tips for Crafting the Perfect TAM Slide

Your TAM slide is a critical part of your pitch deck. Here are five tips to make it stand out:

1. Bottom Up is Preferred: Investors like to see original research and analysis. The top-down approach can come across as lazy—as though the founder simply grabbed some data off Google—and it doesn’t necessarily paint a picture around how the startup sees itself placed in the market.
2. Don’t Over-Inflate the Numbers: Be realistic and accurate. If your product is designed for Gen Z customers, don’t include millennials in the numbers. If it’s for the Australian market, don’t use global numbers.
3. Be Clear on Geography: Clearly define whether your TAM is local, national, or global.
4. Defend Your Price Assumptions: Be prepared to explain how you arrived at your average revenue per user. Have the math ready for when (not if) it’s asked for.
5. Have a Vision for the Future: Highlight how your TAM can increase over time. Show a roadmap for product expansion or market development.

Final Thoughts

A well-researched and compelling TAM can make all the difference in your pitch. It shows investors that you understand your market and have a clear vision for growth. Remember, your TAM is not a static number—it can evolve as your business and market grow. So, keep refining your calculations and stay informed about market trends.

Until next week,

M

Latest from our Prodcircle Podcast

I had an immense pleasure of hosting Anton Federov from Flashpoint VC on the podcast. They are a major player in Europe and Israel - b2b SaaS (series A) VC ecosystem.

This podcast episode with Anton Federov of Flashpoint VC is a goldmine of insights for first-time founders, from the challenges of launching a fund to the qualities he looks for in founders. Anton also discusses the risks and challenges of down rounds and messy cap tables. He highlights the significance of data-driven decision-making and the need for transparency during due diligence.

Watch the full episode here

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